We study the role of vertical structure in determining generating capacities
and retail prices in the electricity industry. Allowing for uncertain
demand, we compare three market configurations: (i) integrated
monopoly, (ii) integrated duopoly with wholesale trade, and (iii) separated
duopoly with wholesale trade. We find that equilibrium capacities
and retail prices are such that welfare is highest (lowest) under
separated (integrated) duopoly. The driving force behind this result
is the risk of rent extraction faced by competing integrated generators
on the wholesale market. Our analysis suggests that vertical structure
plays an important role in determining generating capacities and retail
prices.

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This paper studies how competition and vertical structure jointly determine generating capacities, retail prices, and welfare in the electricity industry. Analyzing a model in which demand is uncertain and retailers must commit to retail prices before they buy electricity in the wholesale market, we show that welfare is highest if competition in generation and retailing is combined with vertical separation. Vertically integrated generators choose excessively high retail prices and capacities to avoid rent extraction in the wholesale market when their retail demand exceeds their capacity. Vertical separation eliminates the risk of rent extraction and yields lower retail prices.